Coal demand is in a near-constant downward cycle as gas-powered plants usurp coal's once-unassailable dominance. As a result, prices have been under immense pressure, and only in the third quarter of 2016 has there been any sizable price increase. We expect that without substantial shifts in market fundamentals, this low inflation environment will persist through 2016 and into 2017.

Prices

Coal prices hit bottom in June 2015. Since this low point, however, prices have crept up slightly to around $43/short ton since the start of 2016. The recent surge in demand during July and August saw coal prices increase, buoyed also by a price recovery across the commodity sector. We do not expect this to continue. U.S. coal continues to languish amid a long-term structural downturn, the result of environmental pressures in addition to low natural gas prices eating away at its power-market share.

For the current year, we expect prices will remain flat as fundamentals fail to support any sort of increase, but with supply contracting, price declines also look unlikely. Our benchmark U.S. coal producer price index (PPI) shows prices will move within a narrow band over the rest of 2016 and into 2017, as shown above. Coal prices remain under strain as power plants convert to natural gas and regulatory pressure tightens. There is some potential upside for prices, however, as the bankruptcy-driven supply-side adjustments currently taking place in companies such as Walter Energy begin to affect the market.

Supply

U.S. coal production is slowly reacting to weakening prices. Indeed, in the U.S. monthly output declined by 31% in the first five months of 2016, at 262 million short tons, compared with 381 million short tons in the same period of 2015. Output reportedly strengthened in June in response to stronger demand, driven by warmer weather, but the longer-term trend remains downward. On a monthly basis, the seasonal effects of power demand are still expected to drive demand, although gas generation has now surpassed coal as the largest source of power generation in the U.S.

Supply is responding to weaker demand; there is no other course of action, so gradual and painful market tightening continues to put intense pressure on the supply base.

Demand

Total US power generation decreased by 0.3% in 2015, following a 0.6% gain in 2014. The 2016 growth rate is expected to escalate sharply to 2.9% in 2016 before moderating to 2.7% in 2017. We also note that the share of coal in the overall US power production portfolio continues to decline. The power sector's switch to natural gas is a major headwind for coal consumption, as the share of coal in the overall US power production portfolio continues to decline. As recently as 2011, coal accounted for 43% of overall US power production, but the ongoing conversion to natural gas has resulted in this share declining to a mere 30% in 2016. While coal is still a very large individual input for US power, the production share of natural gas is growing and is expected to surpass coal, reaching 33% this year.

Demand growth for the rest of the decade is expected to stay above 2%, thus providing support for continued power demand—with 2017 and 2018 expected to produce demand growth of roughly 2.6% and 1.7%, respectively. However, as coal's share of the mix diminishes, conditions will remain tough and demand for coal weak.